Monday, January 28, 2013

Wells Fargo is Cheap!

OK, so in my last post I commented that WFC is a great bank but is fully valued. This thought stuck to my mind over the weekend. Sometimes when I write something (whether blog or email), what I write bounces around in my head and I have second thoughts about it long after I hit the "send" or "publish" button.

I was wondering, is it really fully valued? If it is fully valued, then why does Buffett keep buying WFC stock? He has been buying even before the crisis when the storm clouds were very visible, and even now after financial stocks have rallied a lot.

Why I Said It's Fully Valued
First, let's just look at why I think (or thought) WFC is fully valued. This valuation approach is the same as how people look at other banks like JPM, BAC and others.

ROAROE
Since 1997 1.4% 15.0%
Last 10 years 1.3% 14.5%
Last 5 years 1.0% 10.0%

WFC has a decent, consistent record. One way to look at it is that WFC in normal times can earn 1.5% ROA and a 15% ROE or something like that. With a 15% ROE, WFC can easily be worth 1.5x book value.

As of the end of 2012, BPS of WFC was $27.64/share. 1.5x that is $41.46/share. At $35/share, WFC seems to be trading at a 15% or so discount to what it's worth; not so exciting. Of course, it is still a good, solid holding. If it's worth 1.5x book and the book keeps growing, WFC can obviously still be a great stock to own.

So one way to look at it is that although it may not be trading at a discount to what we think it's worth, it's still a good investment due to future growth.

Just for fun, let's just take a look at what BPS has done over time at WFC. If we are going to pay close to 1.5x book and our returns will come from growth in BPS instead of a valuation adjustment, we have to see what BPS has done and think about what it might be able to do in the future.

So looking at it this way, it's pretty incredible. Look at how much BPS has grown over time, and through the crisis too.

Here are the growth rates of BPS over five and ten year periods:

BPS growth per year
Five years +13.9%
Ten years +11.9%

But BPS growth excludes dividends, so let's add that back and see what BPS growth + dividends would have been:

BPS growth w/dividends
Five years +18.2%
Ten years +17.6%

That's pretty stunning. This kind of record shows that BPS/share for WFC is a no-brainer long. This BPS growth did get a one time bump up from the Wachovia merger, but it's still pretty impressive.

1.5x book value implies a 12%-ish sort of return. Of course, with 1.5x book as a terminal value, then the return can be 18% over time if they do just as well in the future as they have done in the recent past. You can say that the last five - ten years was an outlier bad period for financials (but others would argue that the 2005-2007 was outlier good years so it balances out).

In any case, either way, 15% ROE seems achievable and the same would apply here. You can say 15% ROE = 10% return at 1.5x book, or if you see 1.5x as fair value going forward with no change in terminal value for the foreseeable future, you can expect a 15% return over time even at 1.5x book.

I tend to see things the first way; 15% ROE at 1.5x book = 10% expected return. This may or may not make sense according to what you think. But that's just the way I look at things and I think it's the conservative way to look at it.

Back to Buffett
So let's get back to Buffett. He has been buying WFC even at non-distressed prices. Why? I remember when someone asked Buffett about banks and book value and Buffett said that book value is not important. He does advocate ROE as an important measure of a business, but oddly enough, when discussing WFC during the crisis, he said it's not important. At the time, he said the cost of capital was the most important thing; the one with the lowest cost will win.

(I think he does look at BPS and it is important to him, but maybe other factors are more important depending on the situation).

The other piece of the puzzle is Buffett's goal of earning a pretax 10% return. This is what Buffett has been quoted as saying. At last year's annual meeting I think he mentioned that he likes to pay 9-10x pretax earnings for a good business.

I think a while ago, Munger also mentioned using WFC as a benchmark to evaluate potential investments; if it's not better than WFC, why bother buying something else? I may be wrong, but I do think that within the context of that discussion he mentioned that WFC can earn 10% pretax return on the then current price.

So that also confirms that this is the valuation benchmark at Berkshire.

Now you see where this is going. For financials, the Street often uses 10% as the discount rate; if a financial company can only earn 5% ROE, then it's only worth 50% of book. If it can earn 20% ROE (consistently), then it's worth 2x book etc...

Using Buffett's valuation measure, you will get a different result.

So let's go back to WFC with this new valuation tool (well, it's not new but...).

WFC at 10x Pretax Earnings
In the year just ended, WFC had pretax earnings of $27.1 billion (I added the $9.1 billion in income tax expense to the $18 billion net to common; the pretax income on the income statement includes minority interest and dividends payable to preferreds so $27.1 billion gives us pretax income to common shareholders).

WFC is trading at $35/share now so that's a 70 cent dollar right there. That's 50% upside, not in two years, but NOW!

And keep in mind, this is not intrinsic value or fair value or anything like that; it's a price that Buffett would happily pay for the shares. He says he wants to pay 10x pretax earnings, right? He needs to earn a 10% pretax return, right? Well, $51.46/share gives you that.

But, but, but...
This price would come to close to 2x book. What kind of nonsense is that? How can a financial stock trade at 2x book in this post-crisis, new, new normal world? I know. It sounds ridiculous. If I said this out loud in a bar downtown near the New York Stock Exchange, I would get laughed right out of the room.

But I'm just putting things together. There is nothing new here. I am not making big projections, assuming anything incredible or anything. I just took some facts that are out there and just slapped them together and that's what you get.

Also, I know most people still fear banks and think another crisis is around the corner. Well, if you are a WFC shareholder and see what it did during the last crisis, then you should be praying for another crisis!

Rich Get Richer During Bad Times (or Big Get Bigger)
I will put another piece of the puzzle here. At one of the recent annual meetings, Munger talked about how Rockefeller, Carnegie and others got rich. They got rich during the bad times. When bad times hit, these guys grew by buying up the distressed competitors. This is how it's always been, so it's silly to worry about bad times. Munger said that if you don't get it, you are an idiot (maybe he had a more elegant way of saying it, but I do remember he said it strongly).

I think this was in a context of answering a question about some fear about the future (of the macro outlook, stock market etc...).

And if you look at the above BPS growth of WFC, you can see how exactly right Munger is. WFC shareholders should wish for a financial crisis every year! (WFC grew BPS including dividends at +18%/year in the last five years; it grew BPS + dividends 27% in 2009. How many hedge funds (who are supposed to make money in volatile markets) made a 27% or better return in 2009? And of those that did, how many have not given it back?).

Buying distressed asset funds / private equity funds / hedge funds to take advantage of volatility and bad times may not be a bad idea, but here is a company that is is doing it, right in front of our eyes. They do very well in good times and even better in bad times. Why do people bother looking for someone to hedge their 'deltas', give them non-correlated, leveraged alphas and things like that? Sometimes (or most of the time), the medicine kills the patient; this need to reduce or eliminate perceived risk ends up killing them. And sometimes the answers are just so simple.

Anyway, others will point to the one time-ness of the accelerated BPS gains by WFC because of the crisis, but you can't have it both ways. You can't argue that WFC is no good because another crisis is around the corner, and then worry that the BPS gains in the recent past is one-off so not indicative.

Conclusion
So there you have it. The greatest investor of all time will be buying WFC all the way up to $50/share (and this will keep going up over time). And for those worried about another financial crisis around the corner, you want to own a company that will benefit from it. If you buy WFC and study it's history, you will just start praying for another crisis instead of worrying about it.

What's not to like?

I get it.

(No, I do not own WFC at this time. I have owned it in the past and may in the future. By using the above measure, maybe JPM / BAC / GS are even cheaper than I think they are.)

Really enjoy your blog and have for awhile! Have been in agreement with you completely on fins for the last year (like yourself own BAC/JPM/GS and BKIR). Also, was in complete agreement with your earlier statement that WFC was too expensive. I think as a bank investor here you want your bank to be extending as many mortgages as is prudently possible given low valuations of US housing, wider spreads, better credits etc. So have been wanting to purchase WFC given their aggressive nature in this regard, but I keep coming back to the fact that relative to other similar banks it seems cheaper to buy this exposure through PNC. Very similar ROE, BPS growth, both acquisitive in 09 yet PNC trades 0.9x book vs WFC 1.3x. Interested to hear your thoughts. Keep up the great work!

Would you mind to elaborate how you come up with the rule of thumb that a 15% ROE implies 1.5x BV valuation? And, am I correct to say that this is applicable to banks only? I'm a bit slow here. Thanks.

There is a wealth of financial wisdom in your recent posts on banks. I'm digesting them, slowly...

It's been a rule of thumb for financials for a long time, I think. Investors just want to earn 10% on their investment. So 1.5x BPS on a 15% ROE business is like paying 10x earnings, which is a 10% return. So if a company can only earn 5% ROE over time, then you need to pay 0.5x book for it to be a 10x P/E...

I've been thinking about this valuation issue for some time. I think an underlying assumption is financials can't reinvest their profits at the same ROE. Hence, there is no growth.

Am I making sense here?

I came to this realisation when I looked at this listed soft drink company FIZZ. It got fantastic ROE. But its revenue has been barely in pace with GDP growth in the last 10 years. i.e. It can't grow its market. That got me thinking how to value its superb ROE.

Yes, you are making perfect sense. KO, PG, CL and many others have very high ROE's, but they can't reinvest at that rate so they either buy back stock, pay dividends etc. So their intrinsic value doesn't compound at anywhere close to ROE.

Also, some of these businesses are not at all capital intensive. Or some have depreciated their assets to a large degree but make good returns on assets booked at unrealistic values.

As for banks, they are very capital intensive, and it tends to be their primary ingredient, so ROE is very relevant, and due to their marking much of their assets to market (or at least setting reserves) they are 'realistic' for the most part. We can argue about marks on their derivatives books, loans etc... but in general, they should be in the ball park.

But yes, when the economy is slow like it is now, even with a high ROE, they may not be able to put that capital to work at high rates and this would affect growth to be sure.

But as you see, WFC, JPM and some others tended to have done well in the recent past despite these issues. Going forward, will they do just as well? That's very good question. I tend to believe so, but you never know.

2x book for a large bank isn't that crazy. Check out RY. If high ROE can be sustained, that sort of valuation can perhaps be justified by the investment community (though I do not personally think it is).

1.5x book value implies a 12%-ish sort of return. Of course, with 1.5x book as a terminal value, then the return can be 18% over time if they do just as well in the future as they have done in the recent past.

Sorry, that was a messy paragraph. If something returns 20% but you pay 2x book for it, your expected return is 10%. That's just a simple way of looking at something. If the 2x book valuation is constant (never will change), then the expected return will be whatever the ROE is; if it's 20%, then your investment return will also be 20%.

are you sure about the book value growth including dividends over 5 and 10 years. i come up with 14.9% for instance for 10 years whereas you come up with 17.2%. your figure doesn't make sense given the average dividend yield.

If you just took the BPS growth over time and added the dividend yield, you will get a lower figure than mine as WFC stock has traded as high as 2x book or more in the past. My return all based on BPS. So the return for a given year is not BPS growth + dividend yield, but more like BPS change + dividend/BPS. So the performance of the bank is measured as: (BPS[0] + DVD[0]) / BPS[-1].

point taken on the dividend yield, but i believe my method and your method are the same. i start with 8.98 as the starting book value at 12/31/02 and my adjusted ending book value at 12/31/12, including dividends, is 35.93 instead of 27.64 since cumulative dividends were $8.29 over the 10 year period. that's 300.1% total growth in adjusted book value over the ten year period, which translates into i believe a 14.9% compound annual growth. which of these numbers is incorrect? i can send you my model if you give me an email address.

OK, I see what is going on. In my case, I am evaluating how WFC has created value over time and I add dividends back to book value at the end of the year as it is actually paid out (and reduces BPS and understates what WFC accomplished).

If you compound this, then we get a realistic view of what management has achieved over time so that's good. But the bad thing is that an actual investor wouldn't have been able to reinvest his dividends at book value at the end of each year.

So that is our difference. I should note this when I use this metric in the future. Thanks for posting.

OK. Now i understand. YOu took the dividends and assumed that they would grow as fast as the book value that was already there. That makes some sense. My way was probably too conservative. At the very least I should have reinvested the dividends in the stock price if not at book value. So maybe the truth is somewhere between your numbers and mine.

Thanks for posting. You gave me a heart attack, lol. One of these days, I am going to post about one company with the fundamentals of another. We all make mistakes.

But in this case, I double-checked and my figures are correct.

I reverse engineered your $29.92 BPS for 2012 (googled it) and noticed a FT website used that figure. I found that odd as the earnings announcement has the same BPS figure as I do.

So I did a quick check and my suspicion was correct: FT ( and MSN ) are wrong.

This is what happened. These data vendors are not very careful with their data. They just sweep data multiply and divide without looking or checking.

In this case, they took Total shareholders' equity and divided by the number of shares outstanding. This sounds right. And you do get the figure $29.92/share for 2012-end using this calculation.

The problem is that in total shareholders' equity, preferred stock is included. So to get total common shareholders's equity, you have to deduct the preferreds. This will get you to what WFC says on their website, in their 10-K's and what I use.

So my BPS figures are correct.

As for the five year and ten year being switched, they are not. I just checked my spreadsheet and recalculated manually and they are correct.

In any case, the difference is so small it wouldn't have confused anyone anyway.

Anyway, thanks for pointing things out, though. It's always worth checking and I do appreciate corrections. Again, we all make mistakes.

One concern I have over the valuation techniques being used here (including Buffett's) is that it makes no account for leverage (or it implicitly assumes banks are all levered the same way).

A bank with higher leverage ought to be earning a higher ROE so the cost of equity (COE) ought to be higher to compensate for the additional risk of that leverage. Higher leverage firms should therefore be selling at a lower PE than lower leverage firms (all else being equal) so the Price multiple of pretax earnings should also vary with leverage.

Paying a premium over book value only makes sense if ROE > COE. So what's an appropriate COE for WFC? More generally how would you vary cost of equity for bank leverage?

This is not to say that 1.5x BV might not be appropriate for WFC but rather to ask how one would go about choosing what P/B to slap on a bank as you vary leverage and ROE.

Thanks for posting. Yes, this is only one way to look at WFC. Nothing is a be-all, end-all solution to anything.

But I am pretty confident that this is the way Buffett looks at this.

As for cost of equity, that is a very good, valid question, even though I am not a big fan of the conventional concept of cost of equity (risk-free rate, betas etc...).

But for financials, in general, I think the market uses a 10% cost of equity since they like to price things at 10x p/e (10% ROE = 1x BPS).

You are absolutely correct in pointing out that this really misses a lot of information. How risk is this 10% ROE? Is it highly levered or not levered at all?

This is somewhat of an art form, but I would not be too comfortable with any sort of 'model' to tell you how to adjust for leverage.

Leverage, like anything else, can be very limiting in what it tells you. For example, I would be very, very comfortable with WFC having leverage of 10-1, but not some others.

There's a difference between having a 10-1 leverage ratio with residential mortgages and card loans, for example, than a 10-1 leverage ratio with mostly construction loans.

Even with similar loan types, there is a big difference depending on loan quality, as we learned during the financial crisis.

So the riskiness of a financial institution, to me, goes back to management. Are they good? Are they conservative? Have they been stress-tested in real life and did they come out OK?

These are the things that I look at.

Having said all of that, yes, maybe it's a stretch to compare BRK with WFC, for example. I would not be worried if someone had 100% of their assets in BRK (due to diversified nature, blue chip stock portfolio etc...), but I would warn anyone who had 100% of their net worth in WFC.

Anyway, you make good points and the above are just some thoughts about it. I don't have a solution to compare different financials. I tend to focus more on management anyway, so I may be interested in WFC and JPM even if other financials might have better metrics in terms of valuation etc...

Well, I tend to err on the side of caution. I would much prefer paying below book value for a financial company.

I think basically one has to justify that the ROE is of quality (looking at loan quality as you mentioned would be relevant as well) and not simply a product of the increased risks associated with it. Otherwise you might end up overpaying.

While it looks as though WFC has weathered the storm well I think you discount (and here I'm referencing your other post as well) the role the government has played here. One of the subsidies here is the low rates environment. This isn't being adequately passed on to the consumer. See this for example:

In particular Figure 1 illustrates spreads are quite high compared to recent history. So that's a contributing factor. The spread increased 100 basis points since the 1990's. That ought to be reflected in the ROE figures but WFC's most recent ROE figures (per your figures above) are low in comparison to their historical figures. What would their ROE be if that spread were much lower?

As a side note an interesting space which David Merkel at alephblog has been talking about is insurance. In some recent posts he's looked at historical book value growth, etc of insurance companies. And there you can find a number of companies with solid historical ROE and BV growth selling at discounts to BV. That strikes me as a better opportunity. That way I don't have to worry as much about justifying the quality of the ROE figures.

Your observation on management trust is quite important. Part of that trust will rest on whether or not they hire good risk managers and actually listen to them (as opposed to ignoring recommendation in pursuit of short-term profits).

That's probably another reason why a lot value oriented investors avoid financials. There's that line from Buffett about buying a company that an idiot can run because sooner or later one will. Idiots running a financial company can be quite disastrous.

I would not go anywhere near any financial services stoks including banking stocks. The one sector that I have always avoided is banks thats owning single stocks. However I would buy an exchange traded fund that invests in financial services or banks.

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What is this blog about?

I will post here some thoughts on investing, what's going on in the markets, investment ideas and things like that. This is not a stock recommendation site so don't expect any great stock tips. I am a huge fan of Warren Buffett and other great investors, but there is so much written about them on webites and tons of blogs, so I won't do too much of that here, unless something really strikes me.

As for investments, I will tend to look for interesting opportunities that may not be in the mainstream. Walmart at 11x p/e may be attractive, but I don't know that I can add much by talking about that here. Also Berkshire Hathaway is a great investment, but there is a lot of stuff on the internet about that too. Unless I can add something from a different angle, I won't talk about that too much.

You also won't find me trying to forecast where the stock market will go or what will happen to the economy, nor will I spend a whole lot of time complaining about Bernanke and politicians.

Eventually, I hope to find interesting ideas, special situations, obscure investments, things that don't show up on value screens etc... It is reasonable to assume that I am long stocks that I think are interesting and short the ones that I don't like etc...